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Econ 100b

Created 4/30/1996
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Lecture Twelve

IS and LM Shocks, and Real and Nominal Interest Rates
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 16, 1996


IS and LM Since 1971: Reprise
Slippage Between i and r; Short-Run and Long-Run
The Algebra of Aggregate Demand
What If Expected Inflation Is Allowed to Vary?
Preview of Aggregate Supply


IS and LM Since 1971: Reprise

A potted history of where the IS-LM model says that we have been since the early 1970s. Flatten out complications by looking at unemployment rates and at last-year's short-term real interest rate...

Note that our full-employment model of chapter 3 is of use in comparing pictures across decades. What is the difference between 1979 and 1989?

Remember how an expansion of the deficit would "crowd out" private investment and raise interest rates? Here it is in action.


Slippage Between i and r; Short-Run and Long-Run

Recall how I said that the interest rate that belongs in the IS curve is a long-run, real interest rate; the interest rate that belongs in the LM curve is a short-run, nominal interest rate; and there is a lot of potential slippage there?

How much slippage?
We can see by taking a look in a little bit of detail at 1990-1996...



At the start of 1990 the economy appeared to be doing very well; unemployment in the low 5's; inflation in the high 4's, and perhaps creeping up; federal deficit too large--and threatening to rise, because no one had any stomach for cutting programs and George Bush had pinned himself to the wall with his summer of 1988 campaign promises...

Summer of 1990; Iraqi invasion of Kuwait; fear of another oil shock; let's wait and see on investment--and, in fact, if truth be told, a lot of the time we can never determine, even ex post, exactly why investment demand (or consumption spending) did what it did. But the IS curve heads left from the late summer of 1990.

Unemployment begins a rise that is going to take it from 5.2% or so all the way up to 7.7% in the summer of 1992.

Federal Reserve reacts with a lag. Let's interest rates drift downward through most of 1990, and then in late 1990--when Alan Greenspan decides that yes, the economy is in a recession after all--cuts short-term interest rates relatively rapidly. By early 1991 T-bill rates are at 5.8%, down a full two percentage points from what they were a year before. For most of 1991 Federal Reserve lets short-term interest rates continue to drift downward while it waits and sees what this relaxation of monetary policy will do to the economy. Will this riding down the IS curve offset the shocks that shifted the IS curve back to the left?

Why don't long term rates move?

From late 1991 to early 1992--Federal Reserve realizes that it has misjudged the situation, and drops short-term interest rates from low 5's to high 3's.
White House panics: "playing silly games" with Alan Greenspan; delaying reappointment, et cetera. Poor Bush White House: monetary policy's pre-election impact on output essentially "baked into the cake" by August 1991 or so.

Finally some action in long-term rates--although with falling inflation, it is not clear to me that there had been much reduction in expected real long-term interest rates.

By the summer of 1992, the Federal Reserve is seeing the effects of its actions through mid-1991; doesn't like the continued rise in the unemployment rate; pedal-to-the-floor time: negative short-term real interest rates.

1994: the Federal Reserve decides that the economy is getting too near "full employment"; short-term interest rates up a bunch; long-term interest rates follow almost percentage point-by-percentage point.

1995: Short-term interest rates drift downward: a puzzled Federal Reserve finds production and employment stronger than they thought it would be; yet inflation lower than they thought it would be; and no sign of an "overheated" economy at all. Long-term interest rates come down much faster--nearly inverted yield curve--a bunch of people on Wall Street think that the Federal Reserve is behind events, that there is considerable danger in recession, and that the next move in interest rates is very likely to be sharply down...

Past members of the Federal Reserve Open Market Committee have compared the making of monetary policy to that of driving a car with the windshield painted black by looking in the rear-view mirror.

Add to that never being certain whether the steering wheel is connected to the front axle or not...

Still, widely agreed to be a better job than that of White House Chief of Staff: past occupants of that job have called it "the grease that heats up and needs to be replaced," or "javelin catcher"


The Algebra of Aggregate Demand


(1) Y = C + I + G

(2) Sp = DEF + I(r)

(3) C(Y-T) = c0 + c'(Y-T)

(4) I(r) = I0 - Ar

(5) Y = c0 + c'(Y-T) + I0 - Ar + G

(6) (1 - c')Y = c0 + G - c'T + I0 - Ar

(7) Y = (c0 + I0)/(1-c') + DEF/(1-c') + T - Ar/(1-c')

(8) M/P = L(i, Y) = eY - fi

(9) i = (e/f)Y - (M/P)/f


Suppose we put equations (7) and (9) together--under the assumption that i = r-- what do we get? We get (10):

(10)

Now I'm not going to demand that you regurgitate (10) on any exam. Particularly since Mankiw's textbook writes it differently--and I think oddly--on page 287; calling parameters in the investment function things like "c", which is a mnemonic or consumption if I've ever heard one. If you are going to need (10) on the midterm or the final, I will give it to you.

What I do demand is that if I show you the pieces of (10) you can tell me what they mean.

A lot of fights in the 1960s and the 1970s over equation (10)--claims that monetary policy had no impact, or that multipliers were so small that fiscal policy had little impact. Now we think--especially after looking at what the structural deficits of the 1980s seem to have done to real interest rates, that:



What If Expected Inflation Is Allowed to Vary?



Preview of Aggregate Supply


>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/